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China's Debt Ratings Reminiscent of U.S. Subprime

Cut-throat competition among ratings agencies may be leading to inaccurate evaluation of risks. China's 'Bear Stearns moment' may be just around the corner.

Competition among China’s credit-rating agencies is intensifying, leading to a slide in standards reminiscent of what happened in the U.S. before the financial crisis, according to Dagong Global Credit Rating Co.

China’s onshore bond market faces the possibility of its first default, with Shanghai Chaori Solar Energy Science & Technology Co. having warned this week it may not be able to make an 89.8 million yuan ($14.7 million) interest payment due today. The solar-cell maker sold 1 billion yuan of five-year debt in March 2012, and the notes were rated AA, the fourth-highest investment grade, by Pengyuan Credit Rating Co. when they were issued. The debt was subsequently downgraded twice, most recently to BBB+ in April 2013.

“China’s rating system has problems similar to those in the U.S. in 2008,” Guan Jianzhong, the Beijing-based chairman of Dagong, said in a phone interview yesterday. “There’s cut-throat competition, and it’s not about who accurately evaluates the risks, but comes down to prices and ratings.”

The U.S. Financial Crisis Inquiry Commission said in 2011 that inflated credit grades were partly to blame for the worst downturn since the Great Depression, as rating companies lowered standards to win business amid a housing boom that fueled issuance of mortgage-backed bonds. In 2012 China ended a four-year ban on sales of asset-backed securities, and credit assessments are of growing importance as market forces play a greater role in pricing risk in its $4.2 trillion bond market.

A default by Chaori Solar may become China’s “Bear Stearns moment,” Bank of America Corp. said this week in a report, and may prompt investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008.

The average yield on five-year AA- notes in China climbed 17 basis points in the last four days to 7.82 percent, headed for the biggest weekly increase this year, ChinaBond data show. Ratings of AA- or below are equivalent to non-investment grades globally, according to Haitong Securities Co., the nation’s second-biggest brokerage.

The average yield on junk corporate dollar debt surged to a record 22.66 percent in December 2008, more than double the 9.68 percent at the start of that year, according to the BofA Merrill Lynch High Yield Index. JPMorgan Chase & Co. bought Bear Stearns in March 2008, when the latter was on the brink of failure, and six months later Lehman Brothers Holdings Inc. collapsed in the biggest bankruptcy in U.S. history.

Reform Time

A missed payment by Chaori Solar “won’t pose systemic risks to China’s bond market, but it’s time to think about reforms in improving the rating system,” Guan said. Credit-rating agencies should be made responsible for the grades they award companies and provide more details on how they come up with their assessments, he said. Pengyuan Credit Rating wasn’t available to provide immediate comment for this article in two phone calls made to its Shenzhen headquarters.

Dagong, which cut its U.S. sovereign rating to A- from A on Oct. 17, was set up in 1994 and is one of China’s three biggest rating agencies. The other two are China Lianhe Credit Rating Co. and China Chengxin International Credit Rating Co., which is partly owned by Moody’s Investors Service.

Issuers in China must obtain a rating of AA- or above in order to secure authorities’ approval to sell debt, Guan said. He warned in 2010 that grades assigned to bonds issued on behalf of local governments were misleading and failed to reflect the risks faced by investors.

“The problem is getting worse,” Guan said. “Ratings on companies have been upgraded rapidly not because their repayment abilities have improved, but for the sake of getting bonds sold at lower rates, for getting the business done.”

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